Costco. An aspirational business model?

Advocates for higher employee compensation continuously reference Costco Wholesale (COST) as the model for other corporations to emulate. COST is a profitable company that pays well above minimum wage while also providing good employee benefits.

Last week low-income restaurant and retail trade workers staged a one-day nationwide strike. Their demand? $15 per hour; almost double what some of them were currently making.

Do companies exist to serve those who invest their money, time and efforts in starting and running the business? Or… are corporations merely a tool to provide employees with wages and benefits? If you subscribe to the latter theory it might be difficult to get entrepreneurs interested in risking capital to create new businesses and the jobs that come with them.

Can higher wages and benefits really co-exist with attractive profit margins? The answer is unequivocally, ‘No’.

Costco has never had good net profit margins.

Paying generous wages and benefits to rank and file employees has limited Costco’s average net margins to less than half those of retailing rivals Target and Wal-Mart. During the past decade, the much vilified McDonald’s (MCD) sported average net profit margins more than nine times greater than Costco’s.

How much money a business earns is determined with a simple formula.

Corporate Profits = Gross Sales x Net Profit Margins

More profits over time creates greater shareholder value. Here are fiscal 2012 numbers to illustrate that point.

McDonalds had by far the best margins of this group. Royalties from franchisees cover a large slice of the parent’s corporate overhead. Wal-Mart had the largest total profit due to their enormous sales volume. Target sold 26% less merchandise than Costco but earned almost 67% more dollars for shareholders.

From an owner’s viewpoint Costco was the worst performer of the four.

Costco’s business model is unusual.Costco charges its customers for the privilege of shopping with them, online, at their gasoline pumps or in their stores. The company’s $55 and $110 per year membership fees incur only trivial overhead. They drop, almost 100%, right to Costco’s bottom line.

Those annual fees accounted for more than 100% of COST’s actual net profits during each of the past five years. (See chart below).

Other companies would not want to copy Costco’s business model. If they did, it would not be likely to work for them anyway. Customer demographics are a key consideration. Costco caters to a much more affluent clientele than WMT, TGT and MCD while also sporting a much higher average transaction amount. Sam’s Club and BJ’s use a membership format but do not duplicate Costco’s employee compensation scales.

McDonald’s outstanding 10-year shareholder total return numbers reflect its attention to profitability. The weaker long-term shareholder return for WMT and TGT were mainly attributable to multiple compression. Wal-Mart’s was priced at a very expensive (35x) P/E 10-years ago. Target commanded 21 times its FY 2003 EPS.

Costco’s fine 10-year stock return benefited from the tailwind of a substantial P/E multiple expansion from 18.3x to 25.0x. That is unlikely to be repeatable. The only other time in the last decade that COST hit greater than a 25 P/E was in early 2008. The shares proceeded to plunge from $75.20 to $38.20 in less than one year.

Costco management is willing to sacrifice profits to keep prices low and employee compensation high. That does no favors for shareholders.

Franchise owners of McDonald’s and many other restaurant chains show much lower profits that the public imagines. Increasing wages would force them to raise prices significantly. Trying to absorb higher pay packages for workers would torpedo profits at the local level. That might prove to be both a job killer for current employees and a huge disincentive towards opening new units.

What is the proper hourly rate for an entry level job that requires little skill and no experience? That is an open question best left to the marketplace to decide. Employees that feel underpaid are free to quit, allowing them to accept better paid positions elsewhere.

If no better pay packages are available, perhaps those workers should be happy they are not part of the unemployment statistics we all wait to see each week.

Are any of the stocks mentioned good buys now? Here is a quick cheat sheet summary of my evaluations. All four appear to have only modest upside potential over the next 12-months. My projections do not include dividend yields which would make total return potentials a bit better.

None currently trades at a discount to their own previous 5-years’ normalized multiples. The Fed’s ZIRP policies might support slight P/E expansions if rates do not ratchet up too much.

The verdict. All these are OK to hold. None offers exciting upside. These reasonably conservative, decent yielding stocks are best suited for those merely wishing to outperform cash, treasury bonds or bank CDs.

Comments

At Costco, SG&A is roughly 10% of sales; much less than at WMT (18%) or TGT (20%). MCD is a different beast. MCD generates revenue from its franchisees thereby "hiding" some of the personnel costs at the franchisee level.

It seems higher wages at Costco come with much higher productivity. Costco generates twice as much revenue per dollar of SG&A than TGT and 50% more than WMT. Should wages in general rise, Costco's advantage (greater productivity) becomes worth more in dollar terms.

To me the numbers indicate lower net margins at Costco are not a result of higher wages. They are a result of lower gross margins. Costco marks up it's merchandise 13% over cost. WMT and TGT mark up their stuff more than 25%.

Prices at Wal-Mart and Costco are remarkably similar. I beleive WMT surveys COST and prices accordingly.

Saying any one expense factor, such as labor, does not depress margins is absurd. Money is fungible. All expenses take away from both gross and net margins. Higher wages and benefits definitely have been a large factor in holding Costco's net profit margins consistently to about 50% of what TGT and WMT post routinely.

Many ways to look at an investment. Simplest is "I bought in 2011 for $75 and now it is at $114. 50% return plus dividends." Not too bad. But this is just price, not value.

Any number of companies are branded to bring "value" to customers. Why do people pay more for a Lexus than a Toyota - same manufacturer? Costco pays its employees more and brings a more valuable shopping experience to consumers. The products, stores and personnel are all far superior to WMT. WMT has plenty of customers, and so, apparently, does Costco. _ I own many businesses, including a restaurant, and try to keep labor costs down. However, when we opened, I said "we can never out McDonald's McDonalds" - meaning competing solely based on price is a losing proposition. There is room for a variety of experiences - and we have been profitable since day 1 with paying superior wages and providing superior product. This despite having higher than average COGS and labor costs.

I happen to think Costco does a great service to shareholders and society by not participating in a "race to the bottom." Having said that, I sold my shares when the P/E went above 20 as I think Mr. market has overvalued Costco, and many other consumer companies.

Finally, there is an undercurrent to the article best summarized by your comment of letting the "market" decide on the minimum wage (and your apparent preference for employers to push wages as low as possible). Arguing that the "market" has any intelligence seems anti-thetical to being a value investor. If the market is so smart, how will you find value? Relying SOLELY on the market (Ayn Rand) to fix societal issues is akin to relying SOLELY on the government (communism) to fix societal issues. Both are silly utopian ideals. The income disparity and increasing poverty in this country will be addressed by businesses, the government or the people will address it (ie, strikers you mentioned). I believe I am an enlightened business owner and this means paying a wage that makes my workers also able to be my customers.

Each has their own business model. My point was to show that Costco's decision to pay higher employee compensation has resulted in much lower profit margins than its competitors.

That is what the facts show.

You said, "I own many businesses, including a restaurant, and try to keep labor costs down." That shows that you understand that every extra dollar in employee expense comes right out of your bottom line.

Many people who 'hate' Wal-Mart shop there regularly to capture the best prices even though they disagree with the store's philosophy.

My article was meant to educate. Everyone is free to interpret the content as they see fit.

It astounds me that businesses can continue to pay their best and most hardworking employees little to nothing and still expect genius-scale work from them day-after-day.

Hiring a large quantity of cheap labor is far less effective than properly hiring and paying for the best. 1,000 monkeys get far less done than three people. And if you barely pay people and they leave, just to find someone else who’s willing to work for such a cheap cost, realize you’re not getting the better deal. What you just did is replace a hardworking person with a monkey – you expecting them to think on the same intellectual capacity is absurd.

Even though I have reservation with the conclusion, it's a great analysis. Thanks, Dr!

As long time Costco customer and shareholder(for a while), I think Costco brings unique value to its targeted customers. If the membership fee accounts for more than its net profit, I tend to consider its untapped pricing potential is still there - they raised membership fee only once in many years, and I see plenty of room for fee increase.

In the most recent Sequoia Fund shareholder meeting, they commented on why Target becomes less favorable investment going forward - overlap in product lines(among other things) with Amazon more than other retailers. I believe Costco is one of the least vulnerable big retail companies facing competition from Amazon. Out of the many reasons, Costco still has great potential for geographical expansion both domestically and internationally.

That being said, I'm not buying it at this price and I learned a lot from your analysis.

You said, "I own many businesses, including a restaurant, and try to keep labor costs down." That shows that you understand that every extra dollar in employee expense comes right out of your bottom line.

That is false AND short cited. I am actually the silent partner so not making many of these decisions directly, but we pay cooks much more than the going rate because we can sell better product for more. Increased margins and productivity both can matter as much, or more, than what you seem to be solely focusing on - cost of labor. Further, I have paid for medical procedures and loaned employees money if they are long term because employee turnover is an under reported cost (training, errors, customer satisfaction, waste, etc). Being AWARE of labor cost, as I acknowledged, does not mean that I believe every dollar paid to employees comes from my bottom line - good employees grow the top line and margins enough to grow the bottom line. Crushing labor cost is a race to the bottom and not necessary for many successful business models.

My post was meant to incite thoughtful discussion. If you only transmit (ie, "educate") and do not receive data and ideas, I will not comment again. Not meaning to be rude, just don't want to waste my time.

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